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P2.T6.603. Retail banking credit risks (Crouhy)

Nicole Seaman

Chief Admin Officer
Staff member
Learning objectives: Analyze the credit risks and other risks generated by retail banking. Explain the differences between retail credit risk and corporate credit risk. Discuss the “dark side” of retail credit risk and the measures that attempt to address the problem.


603.1. Retail exposures include the following: credit cards, installment loans (e.g., personal finance, educational loans, auto loans, leasing), revolving credits (e.g., overdrafts, home equity lines of credit), and residential mortgages. Each of the following tends to be a stronger feature of retail credit risk rather than corporate credit risk EXCEPT which is more typical of corporate credit risk?

a. Portfolio tends to behave like a well-diversified portfolio is normal markets
b. Default by a single customer is never expensive enough to threaten a bank
c. A rise in defaults is often signaled in advance by a change in customer behavior
d. Portfolio risk is dominated by risk that credit losses will rise to unexpected level due to concentrations of exposures

603.2. Crouhy writes "The dark side of retail risk management has four prime causes:
  1. Not all innovative retail credit products can be associated with enough historical loss data to make their risk assessments reliable.
  2. Even well-understood retail credit products might begin to behave in an unexpected fashion under the influence of a sharp change in the economic environment, particularly if risk factors all get worse at the same time (the so-called perfect storm scenario). For example, in the mortgage industry, one ever-present worry is that a deep recession combined with higher interest rates might lead to a rise in mortgage defaults at the same time that house prices, and therefore collateral values, fall very sharply.
  3. The tendency of consumers to default (or not) is a product of a complex social and legal system that continually changes. For example, the social and legal acceptability of personal bankruptcy, especially in the United States, is one factor that seemed to influence a rising trend in personal default during the 1990s.
  4. Any operational issue that affects the credit assessment of customers can have a systematic effect on the whole consumer portfolio. Because consumer credit is run as a semiautomated decision-making process rather than as a series of tailored decisions, it’s vital that the credit process be designed and operated correctly. "
Which measure(s) attempt to address the problem of the dark side of retail risk management?

a. Banks should attempt to assign a risk number to these types of wild-card risks
b. Banks should avoid these new types of risks such that they are excluded from the retail portfolio
c. Banks should use stress tests to gauge how devastating each plausible worst-case scenario might be.
d. Banks should allocate (or originate) less than 15.0% of their total mortgage loan portfolio to "qualified mortgages" which are deemed riskier according to quantitative and qualitative criteria; ie, qualified mortgages by definition do not demonstrate "ability to repay"

603.3. The principal risk for a retail credit business is credit risk, but retail banking is subject to a host of other risks. In addition to reputation risk, Crouhy et all list the following four non-credit risks which are faced by retail banking: interest-rate risk, asset valuation risks, operational risks, and business risks. These are described below, but without explicit identification:

I . This risk is generated on both the asset and liability side of the balance sheet. This risk is generally transferred from the retail business line to the treasury of a retail bank, where it is managed as part of the bank’s asset/liability and liquidity risk management

II. These risks in retail banking are generally managed as part of the business in which they arise. For example, fraud by customers is closely monitored and new processes, such as fraud detection mechanisms, are put in place when they are economically justified.

III. These risks are one of the primary concerns of senior management. These risks include business volume risks (e.g., the rise and fall of mortgage business volumes when interest rates go up and down), strategic risks (such as the growth of Internet banking or new payments systems), and decisions about mergers and acquisitions.

IV. This class of risk is a special form of market risk and it impacts the profitability of a retail business line. It includes prepayment risk in mortgage banking, which describes the portfolio's exposure to a drop in interest rates. The hedging of retail assets that are subject to prepayment risk is complex because it relies on assumptions about customer behavior that are hard to validate. Another example is the estimation of the residual value of automobiles in auto leasing business lines. Where this kind of risk is explicitly recognized, it tends to be managed centrally by the treasury unit of the retail bank.​

Which of the following correctly matches the risk to its description?

a. I. Asset valuation risks, II. Business risks, III. Interest-rate risk, IV. Operational risks
b. I. Asset valuation risks, II. Interest-rate risk, III. Operational risks, IV. Business risks
c. I. Interest-rate risk, II. Asset valuation risks, III. Operational risks, IV. Business risks
d. I. Interest-rate risk, II. Operational risks, III. Business risks, IV. Asset valuation risks

Answers here: